Flow-through shares rarely worth the effort

Martin Pelletier: As we approach year-end, many companies in the resource sector are looking to once again tap the flow-through market to raise capital for their upcoming winter drilling programs. Here's what investors need to know

As we approach year-end, many companies in the resource sector are looking to once again tap the flow-through market to raise capital for their upcoming winter drilling programs. Retail stockbrokers are equally happy to once again have a product that is easy to sell given the attractive tax deduction being offered to investors.

However, there are a number of things investors should know about flow-through share offerings before saying yes to the latest deal.

But first let’s step back and take a quick look at how the product actually works. Companies engaged in resource exploration in Canada, in mining or oil and gas, are able to “flow-through” to investors the tax deductions related to the exploration or development of their resources. This is done through a flow-through share offering to the investing public.

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For example, a resource company that requires capital to undertake exploration will typically flow-through their Canadian exploration expense (CEE) to investors via a secondary offering. Investors will, in turn, be able to claim 100% of the value of the purchased shares against their taxes that year. It’s important to note that when they sell their position, a zero cost base is applied in calculating the capital gain.

While this sounds very appealing on the surface, flow-through investing isn’t without its risks.

For one thing, the strong demand for the tax deduction means flow-through shares are almost always issued at a large premium to the market because investors are compensating the company for renouncing their tax benefits to them. Depending on the quality of the company and the state of the broader market, we’ve found that most companies will price their flow-through share offerings somewhere between a 20% to 30% premium to their current share price.

We have a difficult time understanding why an investor would purchase a flow-through deal near this premium

The approximate after-tax break-even price on a CEE flow-through deal for a Canadian in the highest tax bracket would be roughly a 30% premium to the underlying company’s share price, according to our calculations. Therefore, we have a difficult time understanding why an investor would purchase a flow-through deal near this premium when they could simply purchase it in the open market for essentially the same net after-tax cost. Or, in the case of a normal secondary offering, they would be able to buy the company’s shares on average at a 3% to 5% discount.

In the case of a private placement, there is usually a resale restriction of either the time it takes to file a prospectus or 120 days, whichever is less. That said, many of the companies that issue flow-through shares are junior resource companies that will undertake a non-prospectus private placement offering to accredited investors. This means that investors in these private placements will be required to hold their shares for a minimum of four months.

In the aforementioned case, investors will have almost the same after-tax purchase price, but with an associated four-month hold period. A lot can happen in the markets in four months, especially in the junior resource sector.

On rare occasions we’ve seen companies use the capital raised from a flow-through financing for general purposes and were therefore unable to spend it on exploration drilling. Since the company has not fulfilled its flow-through obligation, investors who participated in the financing will have to go back and re-file their taxes. Filing one’s taxes once a year is fun enough as it is.

In conclusion, weigh the risks and rewards before making any investment decision. On the whole, high net-worth investors interested in the resource sector may have better options than participating in one-off flow-through financings. While you will miss out on that warm fuzzy feeling when applying the deduction on your tax return, in many cases simply buying the stock in the open market will do better even on an after-tax basis.

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